Bill Watkins: Fiscal cliff scare tactics

Unless Congress and the president agree on a plan, government spending will fall, and taxes will increase at the end of this year. They call that the fiscal cliff, and almost everybody is saying that catastrophe will result. Bah.

There's really nothing to worry about, but each party has a stake in worry. So, both encourage this idea that a crisis is coming if action isn't taken. The Republicans want to keep taxes low. The Democrats want to keep spending high. So, the parties cooperate in scaring Americans when there is no real risk.

Let's take spending issue. The vast increase in government spending over the past few years has failed to generate economic prosperity. Cutting it a bit won't cause a recession. As the Chicago economist John Cochrane says, "[I]f you didn't buy stimulus from spending increases, you shouldn't fear lack of stimulus from spending reductions."

Besides, the proposed cuts are really small, only about $103 billion on a budget of about $3.6 trillion. It's nothing to worry about.

Then, there is the tax issue. David Ricardo, one of our great early economists, showed in an 1820 essay that government spending is important. How it is financed is not important. The argument goes like this: If the spending is financed by borrowing, the people who will eventually pay back the debt save, because they know they will eventually have to pay. You get the same economic impact as taxes.

The point is that it is the spending that affects behavior, not the fact that much of the spending is using borrowed money. The spending is the problem. As a share of gross product, total government spending (federal, state, and local) now exceeds what we spent at the end of World War II. The WWII spending was an investment. You would be hard pressed to argue that our current spending will provide a similar return.

That's not to say that taxes don't matter. There are efficient taxes, taxes that minimally impact the economy and there are inefficient taxes, taxes that have larger-than-necessary economic impacts. Our current tax structure is inefficient.

High marginal tax rates discourage effort and have negative economic impacts. Collecting the same amount from a person, but keeping the marginal tax rate low will generate an economic gain. Deductions cause higher marginal tax rates and encourage perverse spending decisions. That's why I support getting rid of all deductions and keeping marginal tax rates low.

We do have a problem though, and it is far more serious than the overhyped fiscal cliff. Social Security, Medicare, other entitlement programs and underfunded pensions are eating governments' budgets. Their persistent growth puts all other government-provided goods and services at risk. Their growth is clearly unsustainable, and governments' failure to address the problem hurts the economy by creating uncertainty.

Governments across America and the world have given us no reason to believe that they can address the challenges of entitlement and pension spending without a crisis. In Washington, they delay, posture and obfuscate, unable to deal with even small challenges of a few billion dollars. Eventually, we will reach the day when either our economy can no longer support entitlement growth or taxpayers will refuse to support continued entitlement growth. That will be a cliff.

Bill Watkins is executive director of the California Lutheran University Center for Economic Research and Forecasting and a CLU associate professor of economics.